Reducing Carbon using Regulatory and Financial Market Tools

This paper studies the conditions under which debt securities that make the cost of debt contingent on the issuer's carbon emissions, similar to sustainability-linked loans and bonds, can be equivalent to a carbon tax. The paper proposes a model in which standard and environmentally-oriented agents can adopt polluting and nonpolluting technologies, with the latter being less profitable than the former. A carbon tax can correct the laissez-faire economy in which the polluting technology is adopted by standard agents, but requires sufficient political support. Carbon-contingent securities provide an alternative price incentive for standard agents to adopt the nonpolluting technology, but require sufficient funds to fully substitute the regulatory tool. Absent political support for the tax, carbon-contingent securities can only improve welfare, but the same is not true when some support for a carbon tax exists. Understanding the conditions under which the regulatory and capital market tools are substitutes or complements within one economy is an important steppingstone in thinking about carbon pricing globally. It sheds light, for instance, on how developed economies can deploy finance to curb carbon emissions in developing economies where support for a carbon tax does not exist.